Monthly update on Asia & China Market: Is the worst behind us?

Full transcript:

Aidan: Hello, welcome to our monthly video. My name is Aidan Yao.

Today I’m delighted to have William Chuang, our China equity portfolio manager, on the show to talk about his view as well as our latest thinking on the Chinese economy.

So Will, investing in China equity has been pretty challenging in the last 15 months, what in your view has been the key source of the bearish sentiment and the brutal selling in some sectors?

Will: If we look at Chinese equity performance over the last 3 years, the first quarter performances have been consistently disappointing. In 2020 you had the COVID outbreak but that was followed by a spectacular recovery.  In the first quarter of last year and this year, we’ve seen a very similar pattern with selloffs initiated by concern around inflation and the pace of Fed tightening and how that will impact emerging markets broadly, of which China is the largest component.

If we drill further down on China specific factors, remember, you entered 2021 with sky high valuations only to face decelerating growth in the 2H, persistent regulatory headwind, particularly in the internet sector, and a tightening of financial conditions that lead to solvency issues in the property sector.  So to some extent, de-rating risk was always there.

These were compounded by the Russia/Ukraine situation, which led to global risk off and investors using China as a source of fund. 

Then of course, the strict lockdown measures in Shanghai wreaked havoc, on not just the domestic economy as seen in April macro data, but also made worse the logistics issues popping up around the world. 

So Aidan, summing all of those troubles up, the macro fundamental has not been supportive to equity markets given the growth declines and policy tightening, are you seeing any positive changes in the state of the economy?

Aidan: So, relative to last year, seeing a turn for the worse for the Chinese economy so far in 2022. And the driver is well known – a vicious resurgence of Omicron cases, combined with Beijing’s insistence on the ‘Zero Covid’ strategy, has paralyzed the Chinese economy. Based on our 3rd-party data, as well as we estimate the current growth shock is tracking at around 30% of that in the initial wave of the COVID flare-up, which is consistent with our forecast of GDP contracting by 3% in the current quarter.

What is also quite alarming is the rapid deterioration in the labour market, with the unemployment rate rising to near-record high and youth unemployment at above 18%. This should serve as a strong catalyst in our view for more forceful policy response

So in short, the economy is not in a great shape right now. However, it does appear that the worst is behind, and we are seeing the right policy response trickling through. We just need Beijing to do more, and fast, to truly put a floor under the economy.

So Will, the equity market has seen some signs of life lately after the soothing words from the senior leadership. Do you see March-15 as marking the bottom of the market or is it another false dawn?

Will: At this point, it will take more than soothing words to drive a sustained recovery.  But yes, I think MSCI China, which is heavy on internet platforms listed as ADRs in the US, probably bottomed in March.  And the CSI 300, which represents on-shore A-shares, probably bottomed in late April.  So with that, I do think the worst is behind us.

If you recall when we ran the numbers comparing the long term equity performance of CSI300 with its US comparable, the S&P500, on a 20 year time frame, it showed that the faster growth of Chinese companies did deliver outperformance.  So the thesis of investing in China for growth holds up quite well over the long term and through cycles.

Now, we both know that even though China is a structural growth story, there is a cyclical element to this.  With the current valuation trending more than 1 standard deviation below historical average, the market is telling us that a lot of the bad news we discussed are priced in, meaning the market is likely to respond positively to incremental good news.

We’ve been investing in China for a long time, and the key to being successful really comes down to having the stomach to be a little contrarian.  The most important thing is to be positioned ahead of these cyclical turns. It helps a great deal in our decision making process when we are looking at a trough multiple, which gives us a margin of safety so we can sleep at night.  It comes down to making, perhaps, uncomfortable decisions at times, but in investing, those can be the most profitable ones as well.

How does my view of a cyclical upturn mesh with your outlook of the Chinese economy for the remainder of this year. How long is the lockdown going to be with us?

Aidan: That is a million-dollar question – there are, quite frankly, there are no other drivers of the Chinese economy that are more important right now, right now, than the COVID situation and Beijing’s response to it. We think the development over the past two months have revealed a critical fault line of the ‘Zero Covid’ policy, which is its inability to strike a sustainable balance between virus containment and economic stability.

Hence, we think Beijing has to move gradually away from the current approach, which relies excessively on lockdowns, towards something that is also far from full liberalisation. In other words, we are looking for a middle-of-the-road approach – in between “Zero Covid” and “living with Covid” – is likely, which could feature targeted containment, closed-loop operation, faster testing and vaccination and so on – even though the overall name of the strategy will remain “Dynamic Zero Covid”. Hence, we expect changes to the implementation of COVID policy, but not the name given its political significance.

Some of these changes have already occurred in Shanghai and Beijing lately. And if the authorities can continue the policy fine-tuning, in conjunction with pent-up demand and policy stimulus, we think Q2 could mark the trough of this year’s mini-cycle with growth rebounding healthily in the 2nd half. This could bring full year growth to above 4%, although there are clear risks to that base case given that finding the right balance between containing COVID and saving the economy could prove pretty challenging.

Thank you very much Will for coming on the show, and to our viewers, thank you very much for watching and take care.